TIME activist investors

Shareholder ‘Activists’—Are They Good or Bad?

“Activist” investors are all over the news once again. From Carl Icahn nabbing seats on the board of Herbalife, to Daniel Loeb suing Sotheby’s auction house over its use of a “poison pill” to defend against Loeb, who wants to buy up more stock and put his own people on the board, investor activism is at record highs. According to FactSet Research, activist investors have targeted more than 20% of industrial companies in the S&P 500 over the last five years. There are plenty of reasons for this, as I explained in my cover story about the granddaddy of all activists, Carl Icahn, last year. But the main reason is the most obvious one: Companies are holding more cash than ever on their balance sheets, and activists want them to give it back to shareholders.

The question is and has always been whether this is a good thing. People like Icahn would argue yes — according to him, most corporate boards are made up of lackeys to the CEO, people who typically don’t make great investment decisions and shouldn’t be entrusted with spare cash. Others simply argue that if a company has run out of productive places to put investment capital, then, hey, why not give it back to shareholders?

But I think that there are a fair number of companies out there for which neither point holds true. There’s no question that the share buybacks and dividend payments pushed for by activists boost stock prices in the short term. But as many economists have been arguing for the last several years, there’s never been a better time for companies to do big capital investment projects — from building new factories to buying new technology, expanding overseas, or developing new business offshoots — than there has been since the Fed lowered interest rates to record levels after the financial crisis. We’re now coming to the end of that cheap money era. As Fed chair Janet Yellen indicated in her press conference last week, rates may go up as early as mid 2015. The cost of borrowing will rise, and companies may need their spare cash to pay down debt. No wonder a BofA Merrill Lynch survey of fund mangers shows record support for capital spending, and decreasing support for giving back cash to shareholders.

If activists want to succeed in this new era, they’ll have to argue for more than just big money payouts, and come up with real strategic plans to help the companies they are targeting. Otherwise, they are likely to face increasing push back from investors and experts. For more on that, check out this article arguing against shareholder activism, by well known judge Leo Strine, in this month’s Columbia Law review.




TIME Wealth

Here Comes the Revenge of the 1 Percent

I’d argue that it began with Jamie Dimon’s Christmas card. It showed the last remaining Too Big To Fail banker playing a gleeful game of tennis with his family in their palatial living room (as one does), oblivious to the damage that might be caused by balls crashing into the museum-quality art. But Ben White, who along with his Politico colleague Maggie Haberman, this week wrote the smart The Rich Strike Back, argues it began more recently, with billionaire Ken Langone’s whining that complaints against the rich today are similar to Hitler’s inciting of hatred against Jews in 1930s Germany. Wherever you put down the marker, it is clear the rich are sick of all this talk about inequality and higher taxes—and they aren’t going to take it anymore.

Apparently, politicians think it’s a message that may win over a wider public. White and Haberman’s piece makes an interesting argument that we’re seeing a shift in the Democratic playbook coming up to the midterm elections; inequality and complaining about the rich is too dour, apparently, and doesn’t poll well. Liberals will have to get a new election pitch, one that focuses on the politics of growth rather than “envy.”

What’s interesting to me is that, in some ways, Republicans seem to be going the other way. The speeches given by Rand Paul and Rick Santorum at CPAC were positively progressive in economic terms (well, aside from Santorum calling trickle down economics “spiritual”). They were all about the poor, and creating opportunity, and so on. Republicans have begun to realize that a lot of their base has fallen down the economic ladder and can’t get up. Simply invoking the usual lines about bootstrapping and allowing government to get out of the way so the American can-do spirit can take over don’t seem quite so convincing as we move into the third year of what is still the longest and weakest economic recovery of the post World War II period. The problem is, they don’t really have any new policy agenda to address those problems.

I think that one of the big issues for both parties in both the midterm elections and the presidential election in 2016 will be coming up with some convincing, post trickle-down economic message. We know those old ideas aren’t working—companies and the 1 % have never been richer, but they aren’t creating more jobs. Rather, they are buying more software to do the jobs humans used to do. At a Conference Board event yesterday looking at the effects of technology on the workforce, I was interested in to learn that even as the recovery grows stronger, many companies are considering cutting more jobs, rather than fewer, higher up the food chain, as technology allows them to be done by computers.

The problem is that if you are a politician, how do you message that? The idea of massive structural shifts in our economy that may put hundreds of millions of more jobs at risk globally, increasing unemployment, decreasing income, and possibly requiring a much stronger government safety-net (and probably higher taxes) isn’t nearly as attractive a message as, “Don’t worry – if the rich get richer, you will, eventually, too.” Sadly, it’s the truth–at least right now. And that means that nobody’s heart will bleed for the 1 % very soon.

For more on that, listen to the latest episode of WNYC’s Money Talking, where Ben White, Charlie Herman, and I discuss the issue.


Markets Need Janet Yellen to Kick Them in the Pants

Janet Yellen testifies before the Senate Banking Committee during a hearing on her nomination to become Chair of the Federal Reserve on Nov. 14, 2013 in Washington, D.C.
Kris Tripplaar—SIPA USA

Poor Janet Yellen. She does a good job communicating a complicated (and appropriate) mix of policy decisions at her first FOMC meeting today, including a slightly larger and quicker than expected interest rate hike, as well as a movement away from a set unemployment threshold for keeping rates low and toward a more nuanced view of labor market health. So what happens? She gets hammered by pundits and bankers alike for supposedly ending Bernanke style clarity, adding “mystique” to Fed communications and “shaking up” the US central bank’s mandate of keeping unemployment and inflation low.

Let’s all take a deep breath, please. For starters, Bernanke’s “clarity” over the last few years was largely Yellen’s doing, in the sense that she’s the one that came up with the 2 % inflation target rate and pushed for more and better Fed communication. Then, there’s the supposedly “hawkish” rate increase (the median interest rate forecast increased 0.25 % to 1 %) which investors now believe could happen by mid 2015 based on a statement by the chair, during her press conference, that rate hikes could start six months after the end of asset purchases (which may well be done by the end of this year).

Again, let’s all practice mindfulness, and focus on what we know will happen if rates stay low forever. Bubbles will form—and they will pop. The Fed’s $4 trillion money dump has already created what Yellen and other Fed leaders know are price distortions in everything from emerging market equities to commodities to certain real estate markets. Many people, including me, have been saying for some time now that while we might wish that the Fed’s easy money and low-interest rate policy could do more for the economy, it probably can’t.

There are complicated structural reasons why we are in the longest and weakest recovery of the post WW II period. When I interviewed Yellen earlier this year, she made it quite clear that she knew that the Fed’s firepower was running low—although she still believed that clear and thoughtful forward guidance could help calm markets. (Today’s reaction shows that will be a tricky act to pull off.) Still, by proving hawks that had predicted a Yellen-led Fed would remain too dovish for too long wrong, she’s showing a careful regard for the market impact of long-term loose monetary policy. She may be concerned about the “human impact” of unemployment, but she clearly doesn’t want markets to crash, either.

All in all, I’m rather surprised that the markets took the rate hike news as so hawkish and definitive, given that she stressed again and again that the Fed would be watching a broad range of economic indicators to make sure that they were getting the timing of internet rate tightening right. (Which, by the way, is appropriate given that the recent drop in the US unemployment rate is indicative of many things beyond labor market health, like boomers dropping out of the workforce by choice or by force.) She told reporters that even when rate hikes began, there would be a “shallower glide path” than normal, and that we shouldn’t just “look to the dot plot”—meaning the Fed’s own projections—but that markets should know Fed governors would be keeping their fingers to the wind at all times, ready to change direction on policy if needed.

To me, that’s reassuring. It’s interesting that to markets it was worrisome. That shows just how dependent investors have become on Fed news going in one direction only and how removed some asset prices have become from fundamentals. When I close my eyes, breathe deeply and visualize the future, I see…more volatility.


America’s Most Miserable City Emerges from Bankruptcy

Pedestrians ride their bicycles along the street in Stockton, California, U.S., on June 14, 2012. David Paul Morris—Bloomberg/Getty Images

But at what cost?

Until Detroit, Stockton, Calif. was the biggest municipal bankruptcy in U.S. history. The city, which hopes to emerge from Chapter 9 this spring, has struggled with all sorts of problems in the wake of the subprime crisis—a housing collapse, nosebleed unemployment (it’s still 15.9 % in the city and 13.2 % in the surrounding county), and a mass exodus of firemen, cops and other city service people as the local government struggled with how they could make the budgetary numbers work while still paying gold-plated health care and pension plans to retirees. Stockton did do major cutting in its public sector healthcare benefits, which represented the bulk of its under-funded entitlements. But it’s still left spending 17-18 % of its budget on entitlements like pensions – a number many experts believe is unsustainable. City officials say further cuts just aren’t on the table. “The idea that we’d even look at pension reform meant we started loosing police,” says Elbert H. Holman, Jr., a Stockton council member. “If we’d have eliminated or serious cut pensions, we’d have been devastated as a city.”

As it is, the loss of 400 police officers over four years to nearby cities in better economic shape resulted in a radical increase in crime, and a record number of homicides, 71 in a city of 300,000, in 2012. Reporting in Stockton yesterday, I got an up close and personal look at how desperate things still are thanks to the loss of basic city services. While visiting a tent city of homeless people under Highway 4, one of many in Stockton, my handbag was stolen. Fortunately, two of the tent city residents chased down the perpetrator and got my purse back. “We’re not bad people here,” said Abdul Solo, aged 67, one of those who helped. “We’re just trying to live, stay clean, stay out of trouble.”

That’s a tough job in Stockton, where stories of long-term unemployment and continuing fallout from the housing crisis are still rife (two tent city residents told me they’d lost their homes in the subprime crisis). Nearly every restaurant in the city, mainly fast food joints and small family owned eateries, has a sign like the one at the local McDonalds, which reads, “Service may be refused: this is not a hangout or a shelter.” Indeed, there are few shelters in the city – non profits, rather than the city, support them; paying for care for the homeless is yet another thing that Stockton can’t afford as it tries to craft a budget that will allow it to emerge from bankruptcy without further cuts in retiree benefits. Highway 4’s tent city residents shower and clean their clothes at St. Mary’s, a local Catholic Church. A few blocks away, at the First Presbyterian Church, passers-by are admonished to “give up complaining– and embrace gratitude.”

That’s a message that some city fathers are pushing, too. There are many reasons why Stockton was one of the hardest hit American cities in the Great Recession – a housing bubble, debt spending on white elephant projects (like a downtown arena which is rarely full), fiscal mismanagement, and unrealistic pension return expectations and under-funding during boom times all played a part. The local council understandably wants to move past all that and showcase good news in the city – the Google barge pulled up in Stockton’s port the other day (although nobody seems to know why, exactly); housing prices in nicer areas are starting to go up; crime is down this year from last; the city is convinced that its budgetary math will hold and allow it to emerge from bankruptcy, even as it begins hiring 120 new cops, which was a condition of the recent tax hike that the city was able to pass. But a number of citizens are skeptical. “Stockton’s emergence from bankruptcy will be short-lived under the current exit plan if the pension liability (the city’s largest debt) is not reduced, “ says Dave Renison, president of the San Joaquin Taxpayers Association. “In five short years (2005 to 2010) public pension benefits in California grew at nearly three times that of the private sector.” The fact that statewide pension reform initiatives have so far been torpedoed, “leaves us doing the job for ourselves.”

Mayor Anthony Silva, an energetic and reform minded 39-year-old Republican and former social worker who took office 14 months ago with a mandate to turn the city around, agrees that pensions have been a huge economic drag on the city, but says that “no city can take on pension reform on its own.” Indeed, the fact that 90 % of Californian cities are under the CALPERS system makes it easy for service workers to just leave cities that attempt pension reform and go elsewhere. Mayor Silva is instead focusing his efforts on trying to push economic development in the city, which has the potential to be a bigger logistical hub, as well as trying to find solutions to the increasing bifurcation in a town where preserving the status quo for city workers makes it hard to spend on the most vulnerable. “I’d like to find a way to put some of the homeless to work refurbishing abandoned buildings,” says the mayor, who plans to petition Washington for federal redevelopment money to help Stockton get back on its feet. And despite city council pressure to put the pension issue on the back burner, he says he’d been willing to work with other mayors at a state level to come up with reform ideas. “It’s kind of basic,” says Silva. “You don’t spend what you don’t have.” Tomorrow, I’ll blog about San Jose Mayor Chuck Reed’s ideas about statewide pension reform.

TIME russia

Putin Has Already Lost

Russian President Vladimir Putin speaks during a meeting on economic issues at the Bocharov Ruchei residence in Sochi on March 12, 2014.
Russian President Vladimir Putin speaks during a meeting on economic issues at the Bocharov Ruchei residence in Sochi on March 12, 2014. Michael Klimentyev—AFP/Getty Images

Russia’s economy can’t sustain its leader’s ambitions

With the tumult in Ukraine continuing, there’s been a lot of talk about the U.S.’s major lever in the fight against Vladimir Putin’s Russia: petropolitics. Usually, it’s emerging powers–Russia, Iran and Nigeria–that use the spoils of oil and gas to bolster their influence. Consider that Germany, the world’s fourth largest economy, depends on Russia for about 40% of its energy, and Western Europe as a whole gets a third from it. It’s not hard to see why Europe hasn’t been eager to go along with trade sanctions against Russia in the past (or now). No European leader wants to risk an energy shortfall or peak prices in the middle of a cold winter.

The question today is whether the U.S., which is becoming a major shale-oil and gas producer in its own right, can do anything to help Europe loosen the Russian energy noose. The Obama Administration believes it can and is pushing to accelerate the process of getting American liquefied natural gas (LNG) on line and ready for export. Transportable LNG is the fruit of the fracking boom. Pundits and politicians like House Speaker John Boehner are touting the idea that American energy could make a big difference in Europe, in the struggle with Russia and ultimately in many global conflicts. “The ability to turn the tables and put the Russian leader in check,” Boehner wrote in a Wall Street Journal op-ed, “lies right beneath our feet.”

That view is overly optimistic. J. Robinson West, founder of PFC Energy and a senior adviser at the Center for Strategic and International Studies, agrees. “People have the idea that it’s easy to use energy as a weapon, but it’s not,” he says. “It’s extremely complicated.” For starters, liquefied natural gas remains limited in scope. Although gas is relatively easy to transport via pipeline, you can’t ship it by sea if it’s not properly stabilized. The first LNG export hub to clear hurdles set by the U.S. Federal Energy Regulatory Commission is Cheniere Energy’s Sabine Pass project, on the border of Texas and Louisiana, but it won’t come on line until late 2015 at the very earliest. The next three ports on the waitlist haven’t even been greenlighted. When construction will begin is anybody’s guess.

America’s homegrown shale-oil and gas production is still minuscule. While the U.S. Energy Department is predicting that shale-oil production will climb to about 10 million barrels per day by 2017, right now it’s about 3 million. Given that the U.S. consumes about 37 million barrels per day of fossil fuel, it’s not as if the nation is about to become a major energy exporter overnight.

And when U.S. production reaches levels high enough for potential export, there will likely be a heated debate about whether it should go abroad. America’s budding manufacturing renaissance in recent years has been predicated on U.S. firms’ (particularly energy-intensive chemical and heavy-machinery manufacturers) having easier access to cheap shale oil and gas. Experts like Daniel Yergin, author of The Prize, a Pulitzer-winning history of the oil business, are eager to see infrastructure spending on new pipelines to take Western shale oil and gas to Rust Belt refineries, improving their profitability. The 2016 U.S. elections are on the horizon, and the state of the economic recovery, which remains weak, is still the top political issue. In that environment, it’s hard to see how sending a few million barrels per day of gas to Europe could compete with the larger goal of U.S. job creation and American competitiveness.

The U.S. can’t save Europe when it comes to energy. And it can’t impose truly effective sanctions without Europe’s cooperation. Thing is, it probably won’t have to. Putin’s petrostate will eventually implode all by itself.

Even before the Ukrainian crisis began, Russia was headed toward a major decline. Despite oil prices being more than $100 a barrel, its economy will be lucky to grow at a rate of 1% this year–about one-third of the U.S. rate. The fact that the American economy is growing faster than not only Russia’s but also Brazil’s and those of other emerging-market nations is truly amazing. A decade ago, the BRIC countries were supposed to be the world’s economic salvation. Since then, they’ve become complacent, and their growth has been cut in half. Some, like China, are brewing up epic debt crises. Others, like Russia and Turkey, are ruled by autocratic strongmen trying to grapple with tumbling markets and foreign-capital flight on a massive scale.

The world, in other words, has turned upside down economically. Russia’s pain will continue to be the U.S. markets’ gain, as investors seek safety in U.S. Treasury bills and blue-chip stocks. In economic terms, the war over Ukraine has already been won–and not by Putin.


The Real Debt Crisis We Aren’t Talking About

San Jose Is Wealthiest City In Nation
San Jose, California Justin Sullivan—Getty Images

I spent the day in San Jose, California yesterday, reporting on the city’s effort’s to come to grips with what Mayor Chuck Reed calls a “crisis” in the pension system that threatens the future of the town. At first sight, it seems strange that a town full of techies and which is home to companies like eBay and Adobe can’t afford to fill potholes or keep local libraries open full-time. But gold-plated city pensions are, according to the Mayor, the chief reason that this is the case. And the cut backs that are being made to afford them may actually result in greater economic bifurcation in the city, and higher tax rates for poor and middle class taxpayers, many of whom have little retirement savings themselves.

I’ll be blogging more about what’s happening on the ground in San Jose later in the week. But first, a bit of background on the real debt crisis in this country, the one that we haven’t talked about seriously yet, let alone come to terms with—the retirement crisis. The key stat you need to know: the median household retirement savings for all workers between the ages of 55 to 64 is $120,000. That works out to about $625 a month. A full one-third of the workforce aged 45 to 54 has saved nothing at all for retirement. At a time when social security benefits are being paired back, public pensions are being restructured en mass, and housing growth is flat (only the top 10 markets in the country are predicted to have any significant price increases in the next 15 years), this is a looming iceberg of a crisis.

Declining workforce participation numbers show how quickly the boomers are moving out of work, either by choice or force, and into a retirement in which more than half of them won’t match even 70 percent of their previous income levels. That has implications for everything from over U.S. consumption and GDP growth, to politics in the 2014 Congressional elections and the 2016 Presidential elections, in which boomers will increasingly face off against everyone else for a shrinking piece of the federal pie. (They will likely continue to fight necessary entitlement reform in large part because social security is the only thing most will have for retirement.)

The crisis can be split into two parts. First, the public pensions debacle, which involves only 10 percent of the American workforce, but has economic implications far beyond that, as pension entitlements tank entire cities, like Detroit. Second, there’s the private crisis—only 55 percent of private sector workers in America have access to any kind of formal savings plan, like a 401K. With large companies paring back benefits, and most job creation coming from small- and middle-sized companies that can’t or won’t offer such benefits, the stats will likely get worse in the next few years. California is in many ways ground zero for both the public and private portions of the crisis. Aside from Detroit, the largest public pension fights and biggest municipal bankruptcies have been in places like Stockton, Vallejo, and San Bernardino. Meanwhile, the state also has more retirees, young people without benefits, poor people, immigrants and small- or middle- sized companies than most states, meaning that it hits all the red buttons in terms of citizens who are most at risk in terms of retirement security.

Yet it’s also at the center of the most innovative new proposals about how to fix the crisis. San Jose Mayor Reed is pushing pension reform that would keep benefits that workers have earned but allow changes to benefits earned in the future, and force local politicians to raise a red flag if public pensions are at risk of being under-funded. (The failure to do that, and take responsibility early on, is a key reason many cities have gone bankrupt.)

Meanwhile, in the private sphere, Governor Jerry Brown signed the California Secure Choice Retirement Savings Program, developed by state senator Kevin de Leon, into law last year. This plan, which would be a state-run defined benefit program guaranteeing a minimum level of income for any private sector worker, will require everyone to put 3 percent of their income into a super conservative indexed fund. The idea would be to create a kind of substitute or add-on for social security. It’s getting huge push back from the financial industry (which doesn’t want to lose fees) as well as many conservative state politicians. But it’s already being copied in New York and Maryland. Illinois, Oregon, Washington, Connecticut and even Arizona are taking consultation on similar plans.

If successful, it would mark a sea change in the way we’ve thought about retirement, which everyone admits isn’t working. It would also mean a move back to a new kind of state-run program, very different from the huge entitlement systems of the past, but also different from the do-it-yourself, market knows best ethos of the 401K society that has left most people bereft. I will visit a variety of communities in California this week that reflect different aspects of the retirement crisis – look out for my blogs from San Jose, Stockton and L.A.


What Global Petropolitics Really Mean for You

This week on WNYC’s Money Talking, I chatted about the news story that interests me the most at the moment—the economic backdrop for the escalating political crisis in Ukraine and what the crisis means for the economies of Europe, Russia, Ukraine and the United States. Listen below.


America Can’t Fix Europe’s Russian Energy Problem

Gasoline pump at gas station
Kyoungil Jeon—Getty Images

With the tumult in the Ukraine continuing, there’s been a lot of talk over the last week about how the U.S. may have a major lever in the fight against Putin’s Russia—petro-politics. Usually, it’s emerging markets like Russia that use oil and gas as a political tool. And indeed, the fact that countries like Germany get about a third of their energy from Russia is a key reason that Europe hasn’t been as willing to go along with trade sanctions in the past. Sure, the Russians need Europe as much as Europe needs them (if not more)—about 70 percent of Russia’s export revenues come from oil and gas, much of it sold to the Continent. But no European leader wants to risk an energy shortfall or peak prices in the middle of winter.

The question is whether the U.S., which is becoming a major shale oil and gas producer in its own right, can actually do anything to help Europe loosen the Russian energy noose. The Obama administration believes it can, and is pushing to accelerate the process of getting American liquid natural gas (LNG) online and ready for export. A front-page story in the New York Times hinted that American energy could make a big difference in Europe, and in the conflict with Russia.

I think that view is overly optimistic. Here are three reasons why:

  1. LNG is, and remains, a very localized market. The first LNG export port to clear the Federal Energy Regulatory Commission (FERC) hurdle is Cheniere Energy’s Sabine Pass port, on the Sabine Pass River on the border between Texas and Louisiana. But it won’t come online until late 2015 at the very earliest—possibly even 2016. The next three ports on the wait list haven’t even been green lighted.
  2. The U.S. isn’t producing a lot of shale oil and gas yet, anyway. While the U.S. energy department is predicting that shale oil production will climb to about 10 million barrels per day by 2017, right now, it’s about 3 million bpd. Given that America itself consumes over 90 million bpd of fossil fuel, it’s not as if we are about to become a major energy exporter, even as our own production rises.
  3. We need cheap energy at home if we are going to fuel the manufacturing renaissance. We’ve heard a lot about the growth of manufacturing in America over the last few years. But a big part of that story is easier access to cheap shale oil and gas here at home. American business wants to build pipelines to take Western shale oil and gas to Rust Belt factories to improve competitiveness. If we start to see much of it going to Europe, we may have a political and/or trade fight on our hands.

The bottom line: American can’t save Europe when it comes to energy. The Continent needs to wean itself off Russian gas, no question. But it’s more likely to do that by rethinking its recent reductions in nuclear energy and overly generous subsidies for green energy (which have pushed up prices), as well as by looking abroad to places like West Africa for new energy sources than by counting on the US for a quick energy fix. While America’s push to speed up the LNG approval process may send a useful political message to Putin, it won’t change the European energy dynamic on the ground anytime soon.


How To Fix the Student Loan Bubble—and Banking, Too

Getty Images

New types of lending are coming of age

The US banking structure is screwed up in many ways, but policy-wise, nothing is more destructive than FDIC insurance for banks that do investment banking and trading as well as commercial lending. The fact that we haven’t split up plain vanilla lending from riskier, more leveraged operations has all sorts of perverse effects, the best known being the too big to fail problem.

But as I’ve been looking into the $1 trillion student loan bubble, I’ve found another perverse effect of our misaligned banking system. One of the reasons that the student loan bubble is so big and loans are so onerous is that any bank that is insured by the FDIC can’t actually price risk in the market effectively. There are base student loan rates, all of which are set by the government. Rules about how depository institutions backed by taxpayer dollars can make loans create a situation in which it is very difficult for such institutions to come come in and give, say, a Stanford MBA graduate that has incredibly high earning potential a better rate than a English major at a lesser institution. (Sorry, Edith Wharton fans.)

Now, on the one hand, this policy has its roots in a fair-minded—it helps prevent discrimination by geography or a host of other factors. But on the other hand, it leads to a system in which we have a one size fits all approach to lending. It doesn’t matter whether the default rate at school A is 1 %, and the default rate at school B is 10 %, students must pay the same rates. The difficulty in effectively pricing risk is a key reason that the government, not the private sector, represents 93 % of lending in the student loan market.

But these inefficiencies have created an interesting opening in the market, from which a new financial model is emerging, one that uses peer to peer lending in a way that evokes the community banking models of old. One of the companies at the forefront of it is SoFi, started a former head of prop trading at Wells Fargo, Mike Cagney. Working in the Bay Area, Cagney wondered why extremely marketable Stanford grads with no money but extremely good future earnings prospects had to pay such a high rate to borrow. (After all, most of them are extremely unlikely to default.) He looked into starting a bank to loan to such customers, but ran into the issues I’ve described above.

So, what he did was go to Stanford grads, people who would actually know the trajectory of Stanford students, and ask them to underwrite loans to students at preferred rates, thereby raising money without having to become an FDIC insured bank. The alumni who have an affinity with the people to whom they are lending absorb the loan risk. “They know their customers, in effect, and have an emotional tie with them,” says Cagney. It’s kind of like a modern version of the “It’s A Wonderful Life” community savings and loan model, where you walk across the street to see the people you are lending to. (“The money’s in Joe’s startup. And in Kennedy’s medical practice. And a hundred others.”)

The project, which has been a success in California, started rolling out nationally in 2012. In each market, Cagney would approach alumnae at various colleges (University of Michigan, Penn State, etc) and get them to make initial investments. He has since been able to raise independent financing. SoFi now has over $400 million of loans outstanding with 4,500 borrowers, and will likely do another $1 billion this year, adding another 10,000 borrowers.

This idea is just one of many alternative lending models that are coming of age. SoFi itself is entering the mortgage market, which is ripe for restructuring. More importantly, it shows how badly our overall financial system needs restructuring. Certainly, there are social questions that the SoFi model raises—should we as a society allow students who graduate from better school and want to work in richer fields to get preferred loan rates? Cagney would argue yes, because he believes that a better market pricing of loans would force universities to price degrees differently, and acknowledge that while an Ivy League degree in a STEM or business oriented field might be worth $50,000 to $60,000 a year, many others are not. If that led to a re-pricing of education itself, it could help deflate the loan bubble and make school more affordable. But we’d have to make sure that it didn’t also result in the degradation of liberal arts education, for example, or unfairly penalize kids who simply can’t afford to go to top schools. One solution might be for the government loan system to play a key role there, or for peer-to-peer lenders to package risk in such a way that some of the benefit of premium loans flows to students from less sought after schools in the form of more liquidity and availability of finance.

What’s clear is that it’s not just student loans, but all sorts of risks that are crudely and wrongly priced due to the way that the banking industry is structured. The result means higher capital charges for all of us, but also potentially smaller profits for banks. (Many people, like FDIC vice chair Thomas Hoenig, believe that banks would be far more profitable than they are now if they were split up along business lines rather than allowed to remain conglomerates.) I think that peer-to-peer lending and other alternative models that are closer to the customer than the traditional banking model are will slowly but surely displace Old Finance. After all, who is better at assessing the risk of a credit—a bank, or someone from the borrower’s own community?

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